Leidos-Lockheed IT Merger Fashions Federal Services Powerhouse

Loren Thompson
, ContributorI write about national security, especially its business dimensions.Opinions expressed by Forbes Contributors are their own.

Virginia-based Leidos Holdings Inc. disclosed Tuesday that it will merge with most of the Information Systems & Global Solutions unit of military contractor Lockheed Martin, fashioning the defense industry's biggest pure-play enterprise focused on high-end technical services. The $5 billion transaction, structured as a tax-free Reverse Morris Trust, will give Lockheed Martin shareholders 50.5% of the equity in the combination, and Leidos shareholders the remainder. Lockheed Martin will retain some of the operations of its information-systems unit -- mainly items vital to its military hardware lines -- but will now be focused primarily on the design, development, integration and support of complex aerospace and electronic systems marketed to the U.S. government and overseas allies.

The Leidos-Lockheed merger is one of the biggest transactions thus far in the consolidation of a defense sector that has seen slow growth since President Obama took office and overseas wars began winding down. Most of the deals to date have involved acquisitions and divestitures of properties in the technical-services segment of the defense industry, where contracts typically are of shorter duration and have thinner margins than in the hardware segment. There has been only modest merger activity in the hardware segment because the biggest players have been able to grow returns despite softening Pentagon demand through cost-cutting and increased foreign sales. As a result, all of the biggest makers of combat systems have seen sizable run-ups in their share prices in recent years.

One of the few large-scale transactions involving makers of combat systems was Lockheed Martin's acquisition last year of the Sikorsky helicopter unit of United Technologies. It was in conjunction with the announcement of that deal that Maryland-based Lockheed disclosed it would be selling most of its information-systems business. The dual transactions were designed in part to defuse any Pentagon concern about the size of Lockheed Martin's domestic military revenues -- the units being acquired and divested had similar revenues -- but they also reflected a longstanding desire on the part of Lockheed Martin Chairman & CEO Marillyn Hewson to concentrate her company's business in the integration of advanced military and civil systems such as the F-35 fighter and Space Based Infrared System.

Leidos Chairman & CEO Roger Krone is a marathon runner who is moving to position his company at the head of the pack in the race for high-end federal services business. (Photo Credit: Zaid Hamid)

Such systems typically generate double-digit margins after they enter production, and can contribute to a company's revenue stream for decades. Selling technical services to the federal government, even high-end services such as cybersecurity, tends to be more cut-throat in terms of margins and the frequency of contract re-competes. For instance IS&GS, the unit with which Leidos is merging, has consistently had the lowest margins of Lockheed's five major business units -- generally in the 8% range since the defense downturn began in 2010. Operating margins in Lockheed's hardware units can range as high as 17%, putting some of the company's lines on a par with Silicon Valley tech enterprises. However, making cutting-edge weapons typically requires big capital investments, whereas technical services is more about people; the latter business shines when applying metrics such as return on invested capital.

The difference in financial dynamics of the two market segments helps explain the logic of the proposed Leidos-Lockheed transaction: once it is consummated, each enterprise will be focused on the part of the market where it is best positioned to compete. Leidos will be the market leader in federal technical services, Lockheed Martin will be the leader in complex combat systems (I should mention Lockheed Martin contributes to my think tank and is a consulting client). The merger will be especially significant for Leidos, which will see its revenues double to $10 billion annually, and its workforce grow from 19,000 to 35,000 --making it one of the biggest military and security contractors in the world.

Assuming everything goes as planned, Leidos Chairman & CEO Roger Krone will have fundamentally transformed the enterprise he came to from Boeing in 2014. Leidos, formerly known as Science Applications International Corporation, spun off about a third of its business in 2013 because conflicts of interest among its diverse units were hampering growth. The new combination will have much greater growth potential as the decline in demand for military goods and services bottoms out and the sector begins growing again. Krone, a graduate of the Georgia Institute of Technology, University of Texas, and Harvard thus is positioning his company to be a leader in the highly fragmented federal services market. Although players in that business often complain about the terms and conditions imposed by their government customer, it is a huge market worth hundreds of billions of dollars annually. The new Leidos will have lots of opportunities to take market share from rivals.